Some of us know it as I.R.A while others pronounce it “eye-ruh.” No matter if you’re team “I-R-A” or team “eye-ruh”, you should definitely know what it means!
These letters stand for Individual Retirement Account.
Don’t roll your eyes! I know “retirement” sounds like something you should only worry about when you’re much older, but I promise, you’ll be thankful you learned all about this. It’ll help you learn a couple tips on smart tax moves and ultimately help out your future self!
You probably have a bank account where you put your money, right? So this is still relevant to you! Now, the question is: how much is the money sitting in your account growing each year? If you’re lucky, the answer is somewhere around 2% in the year 2020 (for a high yield savings account). But most people don’t have that. Most people have a checking account that doesn’t pay them any interest at all or a traditional savings account that offers an average of 0.09% in interest per year. That may not sound like a big difference – 2% versus .09% – but trust me: IT IS!
After 10 years of saving $100 every month (or $50 from each biweekly paycheck), a bank account with .09% interest rate or annual percentage rate (also called APR) will have a total of $12,059.56, while a high yield savings account growing at a 2% APR will have a total of $13,402.46. That’s a difference of over $1,000 of FREE MONEY! And, what’s even more eye-opening is that the longer you invest and the more the interest compounds, the bigger the effect. So over a 40 year period of time, which is a typical American working career, the difference is more than $25,000!
What does any of this have to do with that Individual Retirement Account I mentioned earlier? Patience, we’re getting there!
When it comes to money, growth is key. How much can you grow your money in a year? In 10 years? In your working career? With a bank, your money is safe and protected, but it doesn’t really grow that much. That’s where the stock market comes in! It’s a good idea to put the money you may need for an emergency into a bank account for easy and guaranteed access, but also consider putting at least 5% of your earnings into an investment account for long term goals such as retirement.
For example, a 401k through your job allows you to invest your money in the stock market. If you don’t have access to a 401k through your job, then you can open up an Individual Retirement Account (IRA) that also allows you to invest your money in the stock market. Similarly, a pension plan (if you can even get one of those in the 21st century!) also invests your money in the stock market.
So why do all of these fancy accounts put our hard-earned money in the stock market? The answer is: over the long term, (not just one year, but over many, many years) the stock market has a history of providing higher rates of return, thereby growing people’s money much faster than any bank!
When your job doesn’t offer any workplace retirement benefits, then you can open an Individual Retirement Account on your own. Let me break down the basics for you:
What: Opening an IRA
Where: At a brokerage firm of your choice
When: Anytime you want
Why: Because your money can grow more in an IRA than it would in the bank over the long run
Now, let’s talk about the “how.” First, choose whether you want to pay taxes on the money you’ll be investing when you file your taxes next or if you’d rather pay them in the future when you file taxes for the year you took the money out. That will determine whether you open a Roth IRA or a traditional IRA.
Roth IRA vs. Traditional IRA
Roth IRA: Investment account that lets you put money away for your retirement. Money invested here is after taxes have been paid, so you don’t have to worry about paying taxes ever again. Also, any profits you earn over time will never be taxed, and that’s a BIG deal! Available only if you earn under a certain income level.
Traditional IRA: Investment account that lets you put money away for retirement, but claim a tax break on the amount invested when you file your taxes. Since you get a tax break now, when you take the money out in the future you’ll have to pay taxes on your invested dollars and the profits earned. Available no matter what income level you fall under.
People who earn too much money for a Roth IRA tend to choose a traditional IRA (the limits for how much you can earn to have a Roth IRA changes every year.) Also, people who predict that they will earn less money in the future (at retirement) also like to choose a Traditional IRA because they like the idea of paying less in taxes as a result of being in a lower tax bracket.
Once you’ve chosen the IRA type that you prefer, you’re ready to choose a brokerage firm. Choosing a brokerage firm is similar to choosing a bank. Make sure that you know what the fees are, what the customer service experience is like, what account types they offer, and what in-person versus web-based services or platforms they have. You can call them up or go online and create your account. Heads up: You’ll have to link the investment account (the IRA) to your bank account so that you can transfer money and begin to invest in the account you created.
What Do I Put Into My IRA?
Now, the toughest question of them all: What investments do I invest the dollars within my IRA into? The short answer is that it really depends on what your goals are. If you’re not trying to retire anytime soon, then you can afford to be risky. You can have mostly stocks and little to no bonds in the IRA. If you plan on retiring very soon, you’ll want to make sure you have most of your money in more secure investments that don’t change unpredictably in the market, such as bonds. The general rule of thumb when it comes to deciding how much to put in stocks versus bonds looks like this:
120 – your age = percentage of investment that should be stocks
So for example, A 30-year-old in 2020 should have 90% stocks in their IRA and 10% in bonds because 120 – 30 = 90.
Keep in mind that this can vary if you’re comfortable being more aggressive (more stocks) or more conservative (more bonds) with your investments. It’s simply a good rule of thumb to get you started.
One final analogy to help you remember how this works, and then you’re on your way! The brokerage firm is kind of like your bank. It’s where you open the account and do business. Your IRA is like the type of account you open at that bank. It has rules you need to follow and the rules change each year, so do your research. (When can you touch the money? How much money are you allowed to invest per year? Are there income limits on this account?) If you break the rules, then you may pay fees or maybe even penalty taxes. So make sure you understand the rules!
Stocks, bonds, mutual funds and ETF’s are what your dollars can buy and are held within the account. Finally, the annual rate of return is like your APR. While at the bank, the rate of growth or APR is offered to you upfront, that’s not really possible with an IRA or any other investment account because the stock market is highly unpredictable. But remember, historical data shows that it averages much more growth than bank accounts do over the long run, so don’t be afraid to put money aside for the long term if you can afford to.
Now, off you go! You’re ready to open that IRA if you don’t already have one!